How Best to Annuitize Defined Contribution Assets?

Unlike defined benefit pensions that provide participants with steady benefits for as long as they live, 401(k) plans and Individual Retirement Accounts (IRAs) provide little guidance on how to turn accumulated assets into income. As a result, retirees have to decide how much to withdraw each year and face the risk of either spending too quickly and outliving their resources or spending too conservatively and consuming too little. They also must consider how to invest their savings after retirement. These are difficult decisions. Better strategies are available that would ensure a higher level of lifetime income, reduce the likelihood that people will outlive their resources, and alleviate some of the anxiety associated with post-retirement investing. Workers could purchase an immediate annuity that pays a fixed amount throughout their lives, typically starting at age 65. Or they could purchase an advanced life deferred annuity, which requires a smaller share of accumulated assets and begins payments at a later age, like 85. Alternatively, they could use their assets to delay claiming Social Security, effectively buying more inflation-indexed annuity income. This brief, which is based on a recent paper, compares the level of lifetime utility generated by these three annuitization approaches. In all cases, the assumption is that the strategy is incorporated directly into 401(k) plans as the default drawdown option. The discussion proceeds as follows. The first section summarizes the case for commercial annuities and the reasons for their lackluster demand. The second section describes the ÒSocial Security bridgeÓ option whereby participants would automatically use their 401(k) balances to pay themselves an amount equal to their Social Security benefit so that they can delay claiming. The third section describes the approach used to compare the three lifetime income strategies: immediate annuities, deferred annuities, and the Social Security bridge option. The fourth section presents the results. The final section concludes that the Social Security bridge provides the best outcome for households in the middle of the wealth distribution and remains competitive for those at the 75th percentile of the wealth distribution. Introducing such an option as the default in 401(k) plans would require no legislative or institutional changes and would greatly enhance the welfare of plan participants.